04.03.06

Net Present Value

Posted in MBA at 10:22 pm by Jason Permalink

Now for the most valuable lesson I learned in Finance.

I order to identify worthwhile (read profitable) projects one needs to determine its value. This requires us to calculate cash flows resulting from said project and discount them at an appropriate rate to account for the projects inherent risk.

There are two underlying reasons behind the need to discount future risky cash flows:

1. A dollar today is preferred to a dollar in the future. Why? Because when you have a dollar in hand you have greater options available to you. You can choose to consume that dollar or choose to put it in the bank (read invest it). If you are promised a dollar in the future your options as to what you can do with that dollar today are drastically limited.

2. A certain dollar is preferred to a risky dollar. Why? Well this should be obvious. You would much prefer if I told you I will give you a dollar than if I told you there is a 50% chance that I will give you a dollar…

I’m not going to go into how to calculate a discount rate for a particular project… (It is what financial professionals are for) However, I will go through an example.

First, The Present value formula: PV = C/(1+r)^t
Where C is a future cash flow to be received in t periods and r is the per period discount rate. For a project composed of multiple cash flows, sum the individual PVs to get the total PV.

Example: Your company is developing an eStore that will generate cash flows of $2M in one year and $2.5M in two years. The project requires an immediate investment of $1.5M and the discount rate is 20%.

PV = 2/(1+0.2) + 2.5(1+0.2)^2 = $3.40M

The project is going to generate $3.4M, but it costs $1.5M, so we arrive at the Net Present Value by subtracting the initial investment.

NPV = $3.4 - $1.5 = $1.9M

Notice that we do not discount the initial investment because that occurred in today’s dollars, ie at time period 0.

So why do we need to do this? Because not all projects are equally risky and if we compared only their final payoffs we would be comparing apples and oranges… So we need to discount the projects payouts based on both their risk and duration of cash flows to arrive at a common denominator, if you will, that allows for comparison in real terms. This will let us decide if we want project A or B or perhaps even whether we just want to put our money in the bank and wait for project C to come around

We’ll use these concepts in later discussions of Customer Lifetime Value and Stabilizing collusive optimums…